Sunday, February 13, 2005

A REIT to Watch: Affordable Residential Communities (ARC) (III)

My first exposure to Affordable Residential Communities (ARC) came when I saw an ad in the local newspaper about the auction of four manufactured home communities in Washington and Oregon. ARC was auctioning off these properties along with others across the country that do not sit within their primary markets or do not fit their core portfolio parameters. In mid-December, an investor group I cobbled together participated in the ARC auction; however, on auction day, bidding on the properties we had interest in heated up and soon escalated beyond our walkaway bid levels, and we did not end up buying any of the properties.

While I was doing my due diligence on the properties, I also found out about ARC, the REIT. I learned that ARC went public at $19 per share in Feb-2004. The stock has wilted following the IPO and closed last Friday at $12.57, a 34% discount from the IPO price. As I mentioned in my prior post, ARC looks cheap compared to other manufactured home REITs, but is the stock really a bargain at today's price?

The benchmark I selected to calculate our walkaway bids for the property auction was a 20% 5-year IRR with full expenses, capex reserves and round-trip fees accounted for. Let's perform an analogous cash flow analysis on the stock investment:

* Consensus FFO for 2005 is $1.22 per share;
* Take 5-year FFO growth to be 7% (as for peer REITs, Equity Lifestyle and Sun Communities), so that forward FFO grows to $1.71 five years from now;
* Assume that at the end of year 5 the forward P/FFO ratio is 13, in line with the current sector average, giving a final price of $22.24;
* The current dividend is $1.25 per year.

These assumptions give shareholder cash flows of:

Year 1: $1.25
Year 2: $1.25
Year 3: $1.25
Year 4: $1.25
Year 5: $1.25 + $22.24 = $23.49

Requiring a 20% IRR, I discount the above cash flows to end up with a target purchase price of $12.67 (forward P/FFO = 10.4), about where the stock is trading today.

One significant risk is that the dividend currently exceeds free cash flow (AFFO), which I take to be about $1.07 per share (assuming capex to be $100 per homesite, or $6.7 million per year, which is $0.15 per diluted share). Conservatively rounding the dividend down to $1.00 per year, I apply my 20% 5-year IRR requirement again to arrive at the lower target purchase price of $11.93 (forward P/FFO = 9.8).

Another way to gauge value is to view buying the REIT shares as a direct purchase of the portfolio of underlying properties. Annualizing ARC's financials reported for 2004Q3, we have:

Gross income: $62.5 mil. x 4 = $250 mil.
Operating expenses: ($39.5 mil.) x 4 = ($158 mil.) [63% expense ratio]
Net operating income (NOI): $92 mil.

Interest expense: ($14 mil.) x 4 = ($56 mil.)
Preferred stock dividend: ($2.5 mil.) x 4 = ($10 mil.)
Cash flow: $26 mil.
Capex: ($6 mil.) [assumed]
Adjusted cash flow: $20 mil.

(Note that $26 mil. in cash flow implies FFO per diluted share of approximately $0.58, just half of the consensus estimate of $1.22 for 2005!)

Required cap rate: 7.5%
Implied portfolio value: NOI/cap rate = $1.23 bil.

Subtracting off total debt of $1.0 billion and preferred stock of $120 mil., we end up with an implied common equity value of only $110 mil, corresponding to an implied share price of about $2.70 (using 41 mil. shares outstanding). Flipping the calculation around the other way, the current stock price of $12.57 gives a total capitalization (debt + preferred + equity) of $1.63 bil., corresponding to an implied cap rate of 5.6%. Hmm, ARC certainly looks very expensive viewed this way! No one is his right mind would ever pay $12.57 for only $2.70 of underlying value, nor would anyone buy a portfolio of manufactured home parks in today's market at a cap rate of 5.6%.

How do we reconcile the striking difference between our two valuation methods? The first method relied on Wall Street analysts' consensus FFO estimate of $1.22 per share and growth thereafter of 7% per year. This could simply be too optimistic. Alternatively, it could be that ARC really is capable of operating its properties at a much higher NOI than the recent quarter indicates. ARC's peer REITs, Equity Lifestyle and Sun Communities, have operating expense ratios around 45%, compared to ARC's 63% for 2004Q3--there should be room for substantial improvement here.

Since ARC is a new REIT and has rapidly expanded its portfolio through acquisitions over the past couple of years, visibility into earnings right now is poor. This situation is what has driven the stock down so far, creating a potential buying opportunity. With the stock currently trading well below book value (P/B = 0.87), I believe that Wall Street is just overreacting again.

I would guess that ARC will succeed in improving operating efficiency over the next year or so, and that FFO and NOI will rise very significantly. However, I think it best to wait at least until ARC reports 2005Q4 earnings (should be later this month) before buying the stock. During the upcoming conference call, I will be paying close attention to the company's outlook for 2005, occupancy trends, signs of stabilization of the recently acquired Hometown portfolio, and progress with the Hispanic marketing program. With ARC's occupancy at just 81% (compared to Equity Lifestyle's 90% and Sun Communities' 88%), there should be tremendous upside here when management gives proper focus to operations instead of only chasing acquisitions.

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